What Is Sec 174 – Amortization, Capitalization & Key Updates

If your business puts money into research and development (R&D), whether it’s software development, product testing, or experimental research, you need to pay attention. The way you handle those costs for tax purposes isn’t what it used to be.

For years, Section 174 allowed companies to handle R&D expenses in a way that made financial sense. However, major changes have taken effect, which have forced business owners like you to rethink how they manage their investments. 

So, what’s different? And how can you stay ahead? Let’s break it all down in this article by exploring: 

• Purpose, history, and components of Section 174
• Deeper insights into amortization deduction and capitalization of R&D expenses under the law 
• Expenses included and excluded 
• Recent changes and upcoming news 
• Challenges businesses face and how to overcome them

What Is Sec 174?

Section 174 was introduced as part of the Internal Revenue Code in 1954. The goal was to encourage businesses to invest in R&D by allowing them to deduct expenditures eligible from their taxable income. As a result, it was easier for them to invest in new ideas and stay competitive.

History of Section 174

Before 2022, businesses had it easy, as any money spent on R&D could be deducted immediately from taxable income under Section 174. No waiting, no complications – just a straightforward way to lower tax liability and keep innovation moving.

Then came the Tax Cuts and Jobs Act (TCJA) of 2017, and everything changed. Starting in tax years after December 31^st 2021, businesses lost the ability to take an immediate deduction. Instead, they now have to capitalize and amortize their R&D expenditures and spread the cost over a: 

• 5-year period for research in the United States 
• 15-year period for foreign research expenses

The impact?

Businesses that once reduced their tax burden instantly are now stuck. They say, it isn’t just a tax issue but a cash flow problem for them. 

Components of Section 174

If your business is involved in innovation, Section 174 is something you cannot ignore. It lays out how research & experimentation (R&E) expenditures are treated for federal income tax purposes. 

So, what actually counts as R&E expenditures?

Any cost that is related to the development or improvement of property, product, process, software, or technique. This includes: 

• Salaries and benefits for employees involved in research activities
• Raw materials, chemicals, and components used in experimentation
• Expenses for designing, coding, testing, and debugging new or improved software
• Money spent on building and testing experimental models or initial product versions 
• Costs of evaluating product performance under different conditions
• Payments to outside firms for conducting research or testing
• Indirect expenses such as rent, utilities, and depreciation for facilities used in research and much more. 

And what is not included?

• Routine quality control and testing expenses that ensure product quality but do not contribute to new discoveries. For example, a medical device company conducting safety compliance checks before release falls under business expense deductions, not experimental expenditures
• Marketing and advertising costs that focus on selling a product rather than developing it. Say a tech company spends on digital ads for a new app; the amount spent for this wouldn’t be considered development expenses
• General administrative expenses that are unrelated to research. For instance, paying executive salaries, handling legal compliance fees, or renting office space are necessary but do not qualify as reasonable research expenditures

Section 174 vs. Section 41

Section 174 and Section 41 both deal with research-related tax benefits, but they function differently. Up next, we will break down their key differences so you know how to maximize your tax benefits: 

Industries Most Affected by Sec. 174 Regulations

Now that we’ve covered how Section 174 differs from Section 41, let’s talk about which industry is feeling it the most:

• Technology and software development: Companies building custom software, AI models, and cloud platforms now can’t write off development costs upfront. Cash flow tightens, and tax bills rise, which has forced many startups to delay hiring or product launches.
• Biotech and pharma: Drug trials and medical device innovations already take years to bring to market. Now, instead of crossing out qualified research expenditures immediately, companies must spread them over the years, which makes breakthrough treatments even riskier investments.
• Manufacturing and engineering: Developing cutting-edge machinery, robotics, and advanced materials comes with steep R&D costs, and the new tax rules make it even harder to manage finances. Businesses now have to rethink how they fund intellectual property development, prototyping, and large-scale innovation projects. 

Other industries, such as financial services, aerospace, automotive, and defense, also face challenges, particularly companies investing in technology-driven innovation and cybersecurity.

Many startups and small businesses that rely on R&D are also struggling with cash flow because they cannot deduct costs upfront.

Section 174 Amortization 

As we discussed, you can’t just write off your development expenditures right away anymore. Thanks to the post-2021 R&E expenditure rules, you now have to spread the deduction over 5 years for research done in the U.S., while the duration for any research conducted abroad is around 15 years. 

But what does this actually mean?

Let’s say a company spends $1 million on software development costs in 2024 in the U.S. Under the current Section 174 rules, they can’t deduct the full experimental expenses upfront. And the mid-year convention rule delays things even further. Due to this, only half of the annual deduction is allowed in the first year of amortization. 

Let’s understand how it works: 

• 2024 (year 1): Instead of deducting the full $1 million upfront, the company would typically claim $200,000 per year. But that’s not the case either. With the mid-year convention rule in place, they can only deduct half of that in the first year, which means just $100,000 in 2024.
• 2025-2028 (years 2-5): They get the full $200,000 each year. 
• 2029 (year 6): The remaining $100,000 is deducted to complete the full amortization.

Section 174 Capitalization

With the requirement to capitalize research expenses under Section 174, the pre- and post-TCJA eras are completely different. Let’s explain exactly how:

• Immediate vs. delayed deductions: Before TCJA, you could deduct qualified research expenses in full. Now, it’s a must to amortize these costs over time, which delays tax benefits.
• Financial reporting complexity: Immediate expensing kept financial statements simple. The post-TCJA situation has made it compulsory to track amortization periods closely, which makes accounting more complicated.
• Cash flow impact: Pre-TCJA, instant deductions meant businesses could reinvest savings right away. Now, higher upfront tax liabilities limit cash flow and expansion plans.
• Increased burden: Businesses must adjust methods of accounting, track expenditures to capital account, and meet stricter IRS requirements, which adds to administrative responsibilities. 

Impact on Financial Statements and Taxable Income

We would like to add here that the shift in Section 174 rules doesn’t just affect tax filings. It has also changed how businesses report finances and manage profitability: 

• Since R&D costs can’t be deducted immediately, businesses show higher taxable income in the early years.
• Expenditures allowable under Section 174 now appear as assets on the balance sheet instead of immediate expenses.
• As amortization kicks in, deductions spread over time, gradually lowering net income.
• With fewer deductions early on, companies owe more in taxes.
• Some R&D costs may impact the basis of property, which affects depreciation and tax calculations for future sales.

Recent Updates to Section 174

There’s been a lot of movement around Section 174, but no final fix yet. Some of the bills have been passed to restore immediate expensing of R&D costs, but the uncertainty remains: 

1. House Passed H.R. 7024

In January 2024, the House approved the Tax Relief for American Families and Workers Act, which would allow businesses to fully deduct experimental expenditures for tax years 2022 through 2025. Despite a 357-70 House vote, the Senate declined to move forward with it on August 1, 2024. 

2. The American Innovation and Jobs Act (S.866)

This Senate bill, introduced on 16th March 2023, aims to restore full R&D expensing permanently while expanding development tax credits to support innovation. With strong bipartisan backing, the bill remains under Senate consideration, but no final action has been taken yet.

3. New IRS R&D Reporting Rules 

The IRS just made claiming the R&D tax credit more complicated. In January 2022, the IRS implemented stricter documentation requirements for Form 6765. Now, you’ll need to provide detailed breakdowns of research costs, project activities, and proof that your expenses qualify. 

Future Outlook for Section 174

Many discussions have taken place about changing Section 174, but will it actually happen?

With some TCJA provisions set to expire and tax policy up for debate, you need to keep an eye on what’s coming next.

What could change?

• Some policymakers are pushing to reverse the current five-year period amortization rule, but it’s unclear if this will pass.
• Businesses have struggled with what counts as qualified research expenditures, and the IRS has already issued interim guidance. More updates could be on the way.
• If Congress doesn’t fully reverse the rule, they might modify it, such as adjusting how the method of accounting applies or delaying enforcement.

Now, the biggest question is whether Congress will prioritize fixing Section 174 in upcoming tax policy discussions or if it will get pushed aside in favor of other economic issues. 

There are several factors that will come into play to decide this, including: 

• What Congress prioritizes: If tax cuts and corporate incentives take center stage, Section 174 might not get much attention.
• Budget concerns: Reversing R&D amortization would be expensive, and with rising debt, Congress may hesitate. 
• Business pressure: Widespread pressure from the business community affected by Section 174 may force lawmakers to address the issue sooner.

For now, expect the five-year amortization rule to stick, but be ready if things shift. In that case, some of the strategic tax planning steps you can take are: 

• Keep clear records of all development costs, even if you’re unsure whether they qualify. It’s better to have the data than scramble later. This applies to both domestic and foreign research expenses.

Struggling to keep up with R&D expenses? Chrono Platform can do it for you by automatically pulling data from your engineering tools.

‍

• Run financial models to see how different tax policies could affect your business. This helps time product development or enhancements strategically to maximize tax savings and minimize financial risk.
• Look beyond Section 174 to see if development tax credits, the Employee Retention Tax Credit, or other incentives could help lower your tax burden. Just make sure your tax team evaluates how R&D expenses are structured so that claiming one credit doesn’t reduce eligibility for others.

Key Challenges and Solutions For Businesses

After exploring what’s ahead for Section 174, it’s time to dive into the real-world challenges businesses are facing and, more importantly, how to tackle them effectively:

1. Cash Flow Crunch 

R&D spending isn’t just a cost; it’s the fuel for innovation. But with tax deductions spread out over the years, businesses are feeling the squeeze. Less cash on hand means tough choices: scale back projects, cut jobs, or take on debt just to keep things moving.

An affected business owner says:

Solution

Development tax credits like Section 41 can directly offset what you owe, so make sure you're claiming every dollar available. Beyond that, explore funding options designed for R&D-heavy businesses, like: 

• R&D-specific loans
• Innovation grants
• State-level tax incentives

2. Compliance Issues 

Tracking amortization expenses, staying compliant with IRS regulations, and ensuring accurate cost allocation present significant challenges. Get it wrong, and you risk audits, penalties, or delays in filings that could cost you even more.

Solution

The right tax software, like Chrono Platform, can take the guesswork out of tracking experimentation expenses by automatically categorizing costs and syncing with your accounting system. This cuts down on errors and makes compliance easier. On top of that, such platforms can also connect you with expert tax professionals to meet IRS requirements.

3. Accounting and Tax Strategy Shifts

For years, businesses planned their finances around immediate R&D deductions. Now, they’re stuck navigating new accounting methods, unexpected tax liabilities, and a whole lot of uncertainty. It’s impacting everything from cash flow projections to investor confidence.

Solution:

Refine your R&D spending strategy to work within the new amortization rules. Look for ways to offset taxable income by accelerating deductible expenses in other areas, such as overhead costs or production costs. If applicable, explore automatic accounting method changes to optimize tax reporting and reduce financial strain.

How Chrono Platform Helps Businesses Navigate Section 174

Let’s be real: Section 174 is a headache. Monitoring R&D expenses, handling amortization, and staying compliant isn’t easy. 

But what if you didn’t have to do it all manually?

That’s where Chrono Platform can help:

• No more manual tracking – Chrono connects directly to your engineering tools and captures R&D expenses automatically to simplify compliance. 
• Stay audit-ready – Accurate tax filing documentation means no surprises when tax season rolls around.
• Amortization made simple – Let Chrono handle the numbers of financial reporting so you can focus on innovation.

Simplify your R&D expense tracking with Chrono Platform—stay compliant without the headache. Try it today!

FAQs

What is Section 174?

Section 174 of the Internal Revenue Code (IRC) sets the rules for how businesses handle research and experimentation (R&E) expenses for tax purposes. Before 2022, businesses could immediately deduct R&D expenses to reduce taxable income in the same year. However, under the post-2021 R&E expenditure rules, they must now spread these costs over 5 years for domestic and 15 years for foreign research. 

What is Section 174 of the IP?

Section 174 in the context of intellectual property (IP) does not specifically exist. However, IRC Section 174 covers R&D expenses, which directly impact intellectual property development.

What is Section 174 under Trump?

Under the Trump administration, the Tax Cuts and Jobs Act (TCJA) of 2017 changed Section 174, so capitalization and amortization of R&E expenses became mandatory starting in 2022. Previously, businesses could deduct these costs immediately.

What is a notice under Section 174?

A notice under Section 174 generally refers to IRS guidance or updates on how businesses must comply with R&E expenditure rules. These notices clarify amortization guidance, applicability of amendment, and adjustments needed for methods of accounting to align with the latest tax regulations.